Spending to Save Taxes vs. Generate Revenue

A few weeks ago we were speaking to one of our business clients about their tax planning needs for the upcoming year.  During this session, we got to talking about how spending money yields a “tax rate” reduction of one’s taxes for every dollar they spend.  This then prompted the analysis of spending to save on taxes versus to generate revenue.  Let us elaborate.

How Income Taxes Work.  A while back, we wrote about how the income tax system works with regards to refunds and balances due in this post.  The short version is that for each $1 you earn, you have to pay an associated amount of taxes based on your marginal tax bracket.  Conversely, for each $1 you spend on a deductible expense, it reduces your associated taxes by the tax rate applicable to your highest marginal tax bracket.

Spending To Save On Taxes.  One of the things we always try to convey to clients is to spend money on what makes financial, life or business sense.  Don’t spend money to save on taxes; if you receive an associated tax benefit, that’s just icing on the cake.  Why?  Let us illustrate.

Let’s say that Ricky lives in his mothers basement.  She doesn’t charge him any rent, but he gets this “idea” of buying a house so he can get a tax deduction.  So he goes and gets a mortgage and spends $10,000 on mortgage interest, which is tax deductible.  To keep things simple, we’ll assume that all of the mortgage interest is reflected on his return and that his last marginal tax bracket is 25%.  Based on this, he can expect to see his tax liability drop by $2,500.  But let’s look at it another way…

Ricky wasn’t paying anything to live in the basement.  Zero, zip, zilch!  But to get a $2,500 tax deduction, he went out and spent $10,000 on mortgage interest?  In the world of Finance we go by two rules:

  1. Cash now is better than cash later – due to inflation $1 today is worth more than $1 in the future so give me the money NOW!
  2. You only “save” money when you spend $0 – spending money is just that, an expenditure (no matter how big of a discount; sorry discount shoppers).

Using these two rules, it’s pretty clear that Ricky is in violation of the second.

Spending to Generate Revenue.  Thus, if you are faced with a decision to spend money, we usually recommend that you do so to generate more revenue (especially if you are in business).  Why?  There are numerous reasons but some include:

  1. You won’t see as big of a tax reduction as you would hope for by spending it on deductible expenses (see the example above).
  2. Increased revenue will allow you to spend on more beneficial expenses (e.g. increased payroll for yourself).
  3. Who doesn’t like more money?  Oh yeah, the Capital One Baby!

So let’s change things up and assume that Ricky owns his own delivery business.  He files his business income and expenses on a Schedule C so any profit from his business shows up on his personal return and is taxed at his marginal tax rate (25%).  For this tax year thus far, he has $50,000 in profit (income less expenses) from his business.

Instead of buying a house, he decides to spend $10,000 on some billboard advertising.  Now his profit is only $40,000 because the advertising expense is tax deductible.  But those ads generate $25,000 of new business.  Way to go Ricky!  So his profit then becomes $65,000.  Sure, he will have to pay $3,750 more in taxes ($65K – $50K = $15K x 25%) then he would have had to if he didn’t run the advertisements.  But the flip side is that he will be left with $11,250 in more cash.

Now, if Ricky has a smart tax accountant on his team (like us), they might tell him to open a SEP IRA where he could put almost all of that additional $15K above his original $50,000 profit towards his retirement savings.  Best thing about that is 1) it’s deductible on his tax return and 2) he’s funding the day he can park that delivery van for good!

Need some help with your tax planning?  Want to brainstorm on how you can best spend your money?  Give us a call or shoot us an email and we’d be happy to chat with you!

Until next time…

Saving For Retirement in an Uncertain Market

Q: In these uncertain times it’s a little hard to know how to manage our retirement savings.  Is there anything that we should be doing different?  If so, what do we change?

A: In August and September of 2011, there were some episodes of volatility present in the stock market; the likes of which we haven’t seen since 2008/2009.  These were, for a large part, due to three specific events:  the European debt crisis (which just doesn’t seem to want to go away), the political issues that surrounded the debt ceiling and finally the downgrade of the U.S. debt.

These bouts of volatility are often followed by a rash of media coverage.  This is often accompanied by your average investor wondering what they should do, if anything.  Some people will begin to shift their portfolios while others will simply stay the course.  Which action is correct?  To help determine the answer, let’s take a look at four topics.

Perception vs. Reality  The media often makes it appear as if during  turbulent times, investors  are entirely selling out of one area and jumping into another.  While there may be individual investors reacting and moving out of equities and into fixed income or money markets, when we look at the statistics and data, we see that the vast majority of investors stay the course.

Behavioral Finance  This field of study combines psychology and economics in an attempt to explain why and how investors act and to analyze how that behavior affects the markets.  Behavioral finance theorists point to the market phenomenon of hot stocks and bubbles to validate their position that market prices can be affected by the irrational behavior of investors.  What this means in short is, when the markets move around or act in an irrational manner (read volatile), individuals tend to respond accordingly.  This may not be the right course of action, but it happens.

Maintain A Sense Of Balance  One of the best things to do in volatile times is to maintain a balanced portfolio.  Sounds too simple right?  The reality is that it works.  According to Fran Kinniry of the Vanguard Investment Strategy Group “even from the peak of the market, a balanced investor is still positive. And when I say, “balanced,” I mean someone who has a combination of equity investments and fixed income investments.”

For those who struggle with this from an individual standpoint, let’s take a look at it from the market perspective.  Let’s say you have $1,000 that represents all of the investment money in the economy.  Then there are three pails on a set of scales, which represent the sectors that can be invested in (stocks, bonds and cash instruments).  We can put the money into any pail we choose, but the equilibrium between the others will change.  What this means is that one area will make money while another loses it.  Yet one thing will remain unchanged, the amount of money in the market.

Thus, ones best bet is to spread the money around so that when you lose a little in one area, you’ll gain it back in another (and as a whole you shouldn’t be impacted too much).  The problems arise when all of your eggs are in one basket, such as when you are nearing retirement.  If everything you have is in stocks or bonds and the market goes through a prolonged period of adjustment, you may not be able to react fast enough to save your nest egg from severe losses.  Thus, a little asset reallocation may give you that level of protection that you need.

Calculated Market Exploitation  Maintaining a balanced portfolio doesn’t mean that you ignore trends or where the money is being made.  However, what an investor should strive to do is indentify the trends, but don’t attempt to bet the house and ride a wave.  By the time an investor decides to jump into an area that is “hot” or appears to be making money, the reality is that all of the “real” money has been made.  What will remain are the speculators and more often than not, these will be the people who get burned when the market can no longer sustain the inflated prices.

A slightly more realistic approach would be to take a portion of your portfolio (that you won’t miss if things go south) and put it into a general area that encompasses the trend.  For example, gas prices don’t look to be falling anytime soon.  With that said, investing in an exchange-traded fund (ETF) that deals with energy might be a nice hedge in your portfolio.  Energy will probably always make some money and we all know that these companies tend to pay out dividends.  So while you’re not betting on a specific company or stock, you are inadvertently benefiting from investor and market trends.

By |2012-03-02T12:08:37-06:00March 2, 2012|Categories: Accounting Talk|Tags: , , |Comments Off on Saving For Retirement in an Uncertain Market
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